Dimensions: 8'' x 5.25'' 128 pages Crown Business Books Publication Date: July 2002 Hardcover ISBN: 0609609297

July 2002
Bubbleology: The New Science of Stock Market Winners and Losers
By Kevin A. Hassett

The science of identifying financial bubbles is imprecise, although there are landmarks to guide investors on their way. The frontier--whether it is the California Gold Rush or the recent Internet boom--is where bubbles often appear. Investors should be wary of rising prices in the absence of credible information and of a frenzy on Wall Street, which can lead to poor choices. While investors should treat the frontier carefully and look for the emergence of a bubble, the frontier is where the free market is providing the highest returns.

Kevin A. Hassett, a resident scholar at AEI, is also the author of Dow 36,000 (1999, with James K. Glassman), and Tax Policy and Investment (1999), as well as coeditor of Inequality and Tax Policy (2001, with R. Glenn Hubbard).

A financial bubble is a period when the price of an asset (stocks, real estate, tulips, etc.) soars for irrational reasons and then collapses. The search for bubbles is difficult for a simple reason. Price increases are not always misguided. Shares of the major pharmaceutical company Amgen, for example, soared more than 1000 percent in the 1990s, as the firm matured from a promising start-up to a profit-making giant. Such an increase made sense given the enormous success of Amgen's drug development team. Sometimes stock prices soar and stay high. Sometimes, as in the case of many Internet-based stocks, they crash back to earth.

The search for bubbles has been around for centuries, and it has frustrated scientists for just as long. Sir Isaac Newton remarked once, after witnessing the puzzling financial swings of his time, that, "I can calculate the motion of heavenly bodies, but not the madness of people." Economists began trying to do the latter in the late 1970s, but today they are not alone. As the problems involved in detecting stock market bubbles have become well known, scientists from other disciplines, including psychology, evolutionary biology, mathematics, and theoretical physics have joined the hunt. Together these men and women have developed a framework that provides a picture of the breeding ground for bubbles. That foundation has helped us understand within a rigorous framework why bubbles might occur.

Confidence in Markets at Stake

When philosopher Adam Smith wrote The Wealth of Nations (1776), he laid out a conceptual framework that correctly (at least up to now) predicted the triumph of capitalism. According to Smith, the natural functioning of a free-market system sets prices more efficiently than any other mechanism. How much should an apple cost? By matching supply and demand, the market, as if guided by an invisible hand, finds the right price. When markets function well, the price of everything--even the price of a stock--is set rationally, as if by a giant computer. Bubbles are impossible.

Although history has vindicated Smith, a nagging concern has dogged the theoreticians who sought to replace philosophical argument with rigorous mathematical proofs. The conclusion that "free markets always work" was not as robust as many expected. It applied to a very narrow set of unrealistic circumstances. As economists' work progressed, it became increasingly difficult to defend the view that markets were necessarily highly efficient. This was especially true when economists turned to the study of financial markets.

The failure of theory to provide firm conclusions about the stability and the efficiency of financial markets haunted researchers for another reason. Everyday experience often seemed to challenge the view that markets are perfect. Prices for financial assets were prone to sudden and mysterious swings. Crowds of investors bought in a frenzy, drove prices higher, and then stampeded out in panic. It is impossible to overstate how profoundly those facts have disturbed free-market thinkers. If Smith's theory could not be shown to apply to financial markets and if quirky and irrational financial booms and panics occurred fairly regularly, perhaps his entire framework might ultimately be rejected. Since financial markets are crucial to all markets, perhaps Smith was wrong about everything.

The key starting point of bubble research is the observation that a perfectly rational price might not exist when information is scarce. Sometimes it is easy to figure out what something should be worth. Sometimes it is difficult. Occasionally, it is almost impossible. The market sets the prices of shares every day, regardless of how easy or hard that might be.

The market often performs feats of valuation that turn out, in retrospect, to have been strikingly insightful. It is most often the case that things that appear strange turn out to have been sensible under the circumstances. They only appeared strange at the time because the intelligence of an individual is much less potent than the intelligence of the market, which integrates the knowledge of millions. Thus, one should be especially wary of claims that a bubble is present, that the market is all wrong.

When the problem is easy, a fairly rudimentary mechanism sets prices. Folks hungry for apples show up at the farmers market, and a farmer shows up with bushels of apples. One side knows what it wants, and the other side knows what it has. A price naturally and efficiently follows. If the market will close in an hour and the farmer has many apples left, he lowers his price. If a crowd of hungry apple enthusiasts storms the farmer's apple cart and he sells everything in a few minutes, he might decide to charge a higher price tomorrow. There is no reason to believe that the price resulting from such a process is wrong.

But the game is much trickier for financial assets. How much people should be willing to pay for a stock depends on how they view the future of the company. Since the value of such assets depends on what people believe about the future, rather than how hungry they know themselves to be today, the possibility arises that incorrect or irrational beliefs could influence prices. Everything depends on what we believe about the future, but what do we believe? Why do we believe it? Under what circumstances does the past provide a useful bellwether for the future? When are we clueless? One cannot understand bubbles without knowing the answers to these questions.

What we chose to believe about the future depends on our experience. But sometimes, events occur at the frontier of our experience. Dramatic changes in society and the economy--changes that reshape the economic landscape--occur as a matter of course. This frontier is conceptual, not geographic, and markets function differently at the frontier than in the interior. Today new technologies fundamentally change the way we organize our lives. Such changes present us with terribly exasperating challenges, and we often have little to go on. You can tell that you are close to today's frontier when you have no idea what may happen next. You are trying things that no one has tried before.

Why would someone even approach the frontier? For one thing, humans are naturally curious and inventive, and some in particular appear to have an intrinsic need to explore. Perhaps more important, the potential for enormous financial profit depends to a large extent on the presence of uncertainty. Economist Frank Knight raised that point around 1920. He noticed that people who made money did so because they took risks. If everybody agrees that a business will succeed, they all will want to purchase its stock today. The price will be high today, and the potential for enormous gain in the stock price and hence for investor profit will be small. If there is significant disagreement about the future of a business, however, there is a chance that you can buy it for a small sum today and sell it for a lot tomorrow. If the business succeeds, and everybody knows that, the stock will be worth more. Unusually large profits are available only when nobody knows for sure what might happen.

The study of that uncertainty--and the way the human mind responds to it--has started a revolution. Two types of uncertainty exist--and the distinction between them is crucial for students of the bubble. The first--often called risk--is introduced because of random factors within the realm of existing human experience, factors that have well-defined probabilities. For financial markets, such risks are discounted all of the time. Frost might destroy an orange crop, for example. People who want to bet on a big increase in juice prices pray for frost. Those who want to bet on low juice prices pray for warm weather. Nature decides the winners. Markets and people function efficiently when faced with such risks.

Investors and Ambiguity

The other type of uncertainty--ambiguity--is the result of the absence of reliable information about future events. If you sail a boat across the North Atlantic for the first time, what are the chances that a sea monster will eat your ship? A scientific genius has walled himself into his garage; he is intent on finishing a secret invention that he believes will completely alter society. What are the chances that he will succeed?

At the frontier we are not worried about the weather, but rather are haunted by ambiguity. There is no reliable information about what might happen, or the probabilities of different eventualities. This ambiguity has a strong psychological effect. Part of us wants to be daring and join the avant-garde with all our energy and resources, while another part wants to stake out a safe and pleasant existence far away from the raging battles. Our markets work to funnel money to the frontier because the potential for profit there is great, but each of us must face that most terrible question: Should I risk my own savings?

How do humans act in the presence of ambiguity? The study of that behavior started with a clever paper published in 1961 by a brilliant young Harvard graduate student named Daniel Ellsberg, who asked his undergraduate students to participate in a simple experiment involving two urns. The first contained one hundred little balls, fifty red and fifty black. The second also contained one hundred balls, but students were not told how many were red and black. Students knew that they would win a prize if they selected a red ball and were allowed to pick from either urn. The experiment, since replicated thousands of times, produced shocking results. Students avoided picking from the urn of mystery at all costs.

Ellsberg, an early student of information theory, performed the experiment because information theorists had concluded that rational students in such a setting should be indifferent between the two urns. Since they had no information about how many balls of each color the urn of mystery held, they should have acted as if the urn contained fifty red balls and fifty black balls. Any combination was possible, and all combinations were equally likely. The logical odds of pulling a red ball were the same for both urns. Yet something bothers us about that conclusion. We can understand it rationally, but our actions often suggest that our intuitive selves are unwilling to act on our logical mind's instructions.

Good and Bad Swings

Recent evidence suggests that some price movements are sensible, and some are not. Bubble researchers have divided them into groups and have found some provocative common themes. When information is valuable and clear, bubbles cannot happen and price movements are sensible. When ambiguity is high, shareholders take clues from each other's actions, and cascades can follow.

So how can one tell whether the latest movement is good or bad? Though not about stock investments, the case of a Philadelphia man who made one of the largest percentage profits of all time provides an example of a good price swing. In the spring of 1989 our collector wandered through a Pennsylvania flea market and found a hideous painting, a dark country scene with an illegible signature. The frame, however, was attractive, so he offered the seller $4 for the painting. At home the purchaser separated the frame from the picture and discovered that the frame was crudely made and even less valuable than the painting. He would have to throw the painting and frame away. There was nothing left to save.

Or was there? Behind the back panel he discovered one of only seven unframed and unbacked copies of the Declaration of Independence. When asked to authenticate the paper, Sotheby's experts declared the document as crisp and clear as it was on the evening when John Dunlop printed it. Two years later the copy was auctioned for $2.42 million.

We can be fairly certain that the purchaser, upon finding that he possessed a rare copy of the Declaration of Independence, suffered no anxiety that his investment would suddenly drop back to its original $4 value. And we can be sure that news stories about his fortunate turn made no reference to mania despite the fact that he made millions overnight. No, the profits were deemed both secure and sensible because the purchaser had discovered something new about the painting after he took it home. The news that the painting contained a priceless American relic justified his enormous profits. That is a "good" price swing.

Such unanimity of opinion does not accompany every happy investment return. At times markets puzzle even the most committed free-market disciple because unquestionably "bad" price swings occur.

In November 1997, a Nature article reported that Entremed, a start-up biotechnology firm was developing drugs that might be the long-desired cure for cancer. Entremed's stock rose from $11 to about $15, a healthy increase, but nothing extraordinary.

What happened next was extraordinary. On Sunday, May 5, 1998, a front-page New York Times article introduced the potential of the Entremed drug to the general public. It is an understatement to say that the response was enthusiastic. Everybody wanted a piece of the firm that might find a cure for cancer.

Entremed's share price was $12 the Friday before the Times article. The price opened Monday at $85 per share. The buying frenzy did not stop. The NASDAQ biotech index increased 7.5 percent that day. A few months later bad news was released. On November 12, 1998, the Wall Street Journal reported that other labs had failed to reproduce the Entremed study. The stock fell sharply that day, to $32--still more than twice the price on May 1!

Such swings severely test those who believe that the stock market moves up and down for purely rational reasons. Perhaps the New York Times article gave a certain credibility to the earlier Nature article, a credibility that might justify a price increase. But should such an event make the prices for all other biotech stocks increase? Why did other firms that were investigating cancer cures see their prices increase? Might not Entremed's success make their drugs superfluous?

Finding bubbles requires knowing where to look and for what. Near the frontier, assets (such as the Entremed stock) may swing wildly in price for odd reasons that do not relate to fundamentals. Assets such as the newly discovered Declaration of Independence are akin to the safe interior of an established country, where there is security and safety. They often increase in value because new information is acquired that signals good news. Examples of both types of movement abound.

Frontier Economics

Is the fact that bubbles exist bad news? Perhaps not. Bubbles occur because of the highly ambiguous prospect of enormous profit, because an explorer or entrepreneur is close to paydirt. Such circumstances have occurred often. Indeed, the parallels between the most recent Internet episode and past episodes is striking.

One of the closest experiences in U.S. history was that of the California Gold Rush. On January 24, 1848, a California construction superintendent named James Marshall discovered gold while he was building a sawmill on the south fork of the American River. Word spread rapidly that gold had been found on the mill property owned by John Sutter, and men immediately swarmed the rivers of California prospecting with shovels and pocketknives. For the first men, there was much gold to be found. The average daily earnings of miners along the American River ranged from $800 to $15,000.

One hundred and fifty years later, the Internet boom set off a similar gold rush with many telling parallels. While some of the earliest prospectors became rich beyond their wildest dreams, many ordinary investors lost significant portions of their hard-earned savings by investing in shaky companies whose prices were inflated for no good reason. But the problem facing these investors was as difficult as that facing would-be Forty-Niners. New territory, previously unexplored, appeared to be cluttered with gold. Nobody could be sure how much gold was hidden there, but if gold was there, then the early birds would be the fattest.

Both of these episodes fit neatly into the view of bubbles that has survived the give and take between the warring conventional wisdoms. Bubbles exist, but they are not everywhere. They emerge where the economic world is the newest, and where information is the poorest. They happen when the opportunity for great profit is real, but shrouded in ambiguity.

When the next rush occurs, we will each have to decide once again whether to participate. Should you purchase the wildest high tech stocks again? History provides clues about how to make that decision prudently. First, stay away from firms that increase in price sharply when there is no news. The best firms will make money and increase in price when the market learns that they will make even more money. Second, when the frenzy is at its highest, unwary shareholders gobble up everything that Wall Street is willing to throw their way. Wall Street has never ignored a chance to make a quick profit, and accordingly, new offerings that appear in unusually good times have unusually bleak prospects. Do not buy them!

Bubbles are most likely when the free market is providing its highest returns. While some may believe that the days of the frontier are behind us, the opposite is most likely true. The information technology revolution enhances our ability to try new ideas and explore new possibilities. New economic frontiers will emerge with increasing frequency as a result. This is both scary and exhilarating. A unique willingness to push the frontier perhaps explains better than anything else the remarkable success of the American economy. Yet that wealth has come in uneven spurts, with many false starts. Fortunes were made and lost, and will be again with increasing frequency.

In the end, however, those who decided to stay on the farm in upstate New York and skip the gold rush did not acquire great wealth. Some of those who marched off to California did. And both were better off because so many were willing to risk it all and head for the frontier.